Derivatives occupy a niche section of the market. Instead of having value directly, such as a stock’s price based on the value of a company, futures and options derive their value from speculation about an underlying asset.
Telling these products apart can sometimes be tricky because they share structural similarities. Yet futures and options stand apart in many important ways. Understanding exactly how is important to judging their role in your portfolio.
First, where they’re the same.
Options and futures both trade contracts to buy or sell an underlying asset. These contracts can be for commodities, such as coffee beans, or financial products, such as stocks and bonds, and they use the same terminology.
A “put” contract gives you the right to sell assets in the future, while a “call” contract gives you the right to purchase them.
(They should also be distinguished from a “forward contract,” which is a similar vehicle traded between private parties rather than over a public exchange.)
So, for example, let’s say you buy a July 7 call contract for 10 tons of coffee at $1.70 per pound on the futures market. You’ve made a contract to buy this coffee at that price on that date.
That’s great if beans go to $1.80 because you’ll have a contract to buy it below market price, while if coffee drops to $1.60 you’ll take a loss by being locked into an overvalued purchase.
The same goes for a put contract. On July 7 you have the right to sell 10 tons of coffee beans at $1.70 to whoever holds the contract. Here, if beans are worth less than $1.70 you profit by selling above market value. If they’ve gone up in value, you take a loss by selling below.
(In a put contract, remember, you have to acquire the beans first. So you’d need to pay to buy beans for $1.80 per pound and then resell them at the agreed-upon $1.70.)
The main difference is relative to certainty. Futures are a contract for transactions that definitely will happen. Options, on the other hand, give an investor the right but not the obligation to execute.
So, for our hypothetical coffee contract on the futures market, the investor is locked into her purchase on July 7. With a coffee option, though, the investor can walk away if the deal looks bad.
So if our investor makes her purchase a call option for 10 tons of coffee and the price tumbles to $1.60, she can simply walk away. If the price goes up, though, she retains the right to buy for $1.70.
This makes options a more secure form of investing, but security comes at a price.
Investors can trade futures for very little money down. This low margin payment makes them risky but also potentially very profitable.
Options, on the other hand, have higher initial premiums (the term for option upfront costs). That greater expense means that your investment needs to do better before you can profit, but it also buys security and flexibility.
And, while an option contract’s losses are capped at the premium, a futures contract is unpredictable.